July was a surprisingly good month for financial markets, with the greatest monthly gains since 2020. The S&P 500 was up 9.22% during the month, the Dow Jones Industrial Average was up 6.82%, and the Nasdaq Composite was up 12.39%. While all three indices are still down for the year, last month reversed a significant share of the losses. Internationally, developed markets rebounded, although emerging markets didn’t do as well as expected.

Looking Back
Interest rates. Interest rates drove the markets in July. While the Fed is publicly committed to keeping rates rising until inflation is under control, there are signs that inflation is moderating. In July, we also experienced growing concerns about a recession. The mid-month announcement stating that the economy contracted in the second quarter—for the second quarter in a row—led to headlines proclaiming a recession and spooked markets. Between signs of a peak in inflation and recession worries, which have markets expecting a cut in rates next year, interest rates pulled back sharply in July. After peaking early in the month, the U.S. Treasury 10-year yield dropped sharply, from a high of almost 3.1% to 2.65%.

Valuations. Lower rates typically mean higher stock valuations, and this was a significant driver for the strong July performance. The drop in rates started to reverse in early August, so there could be more pressure on markets. That said, even though valuations have risen a bit, they remain in a pre-pandemic range, which should limit the impact over the next couple of months.

Corporate earnings. With valuations in a reasonable range, the principal fear shaking markets in August will be the effects of a recession on corporate earnings. Looking back at July, which was the start of the second-quarter earnings season, the data was not as bad as expected. While growth had slowed, aggregate earnings continued to surprise to the upside. That trend will likely continue in August for second-quarter earnings. As more data is reported, however, attention will shift to the expected third-quarter earnings, which brings us back to recession worries.

The economic data. While recession fears worsened significantly in July, the actual economic data was not nearly as worrisome. Hiring, in particular, remained strong, and consumer confidence showed signs of stabilizing. Business confidence and investment also remained healthy. So, while the economic growth report was negative, most other data was positive.

Looking Ahead
Moderating headwinds. Hiring is expected to slow somewhat but remain above pre-pandemic levels, even as the labor market approaches full employment. Consumer confidence was hit hard by higher gas prices, but as oil prices have pulled back, confidence should continue to stabilize. While there are headwinds, they should continue to moderate in August, supported by the substantial momentum of the economy.

International turbulence. August should see other worries moderate as well. Besides inflation, interest rates, and the weak economic report, news from the war in Ukraine and the Chinese Covid-19 shutdowns also hit the headlines in July. The worry and the damage were real—but, looking forward to August, both of those risks have stabilized. Overall, the economic effects of the major international issues should continue to fade in August, with supply chains easing even as oil and wheat prices pull back. Covid-19 could surge again, Taiwan may become a flashpoint, and the Ukraine war could expand. And when and if those bad things happen, we will see more market volatility. As always, the headlines will drive short-term market performance.

Market improvement. July marked a significant rebound in markets, even as economic fears grew. Looking forward, August should start to indicate whether the rebound will continue. With the economy still reporting positive data, and with worries starting to moderate, we should see valuations remain stable and possibly improve. We may even see appreciation, as fears about earnings growth begin to moderate.

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